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Italy: troubled waters and complex challenges ahead but no Italexit on the roadmap!

In just a few days, investors have shifted from perhaps excessive complacency to excess pessimism about Italian politics. Volatility is likely to remain for some time, as Italy is entering into unknown territory in terms of governance, which is perhaps worth a specific political risk premium. However, even if a serious confrontation is inevitable between the new government and the European institutions (on immigration, fiscal policy and foreign policy), we do not expect an imminent default risk or euro exit. Weaknesses in the Italian economy are well identified (public debt, very low potential growth, low productivity), but the economic situation has improved significantly in recent years. As long as monetary and financial conditions remain accommodative, the recovery in Italy should continue.

June 2018

June 2018

In just a few days, investors have shifted from excess complacency just before the turmoil (MIB index up 10% since the beginning of the year, stable sovereign spread despite the uncertainty concerning the government) to excess pessimism (fall in the stock market, surge in sovereign spreads to their highest levels since 2013); the shock was even more pronounced on short-term interest rates than on long-term rates. This implicitly means that investors were beginning to price - with a significant probability - a break-up of the Eurozone (Italexit) and as a result a sovereign default.

We must keep some common sense:

Even if a serious confrontation is inevitable between the coalition government and the European institutions (on immigration, fiscal policy and foreign policy), there is no default risk in the coming 2 to 3 years.

Surveys have always shown (so far) that Italians do not want to abandon the euro. And this clearly explains why the two anti-system parties which form the new government coalition have never had this proposal on their agenda (and did not campaign on this issue).

The room for manoeuvre of the new government is limited by the constitutional prerogatives of President Mattarella who can veto certain laws (if they lead to an unsustainable drift in the public debt-to-gdp GDP ratio or if they go against international Treaties).

The economic situation in Europe and Italy has improved significantly in recent years. The recovery in the Eurozone has been vigorous and the Italian economy has found the way to growth and even returned to trade surpluses. As long as monetary and financial conditions remain accommodative, the recovery in Italy should continue.

Very low potential growth (public debt sustainability at risk in the medium to long run)

A recovery that is still too weak to increase the GDP-per-capita (its stagnation since the great financial crisis contrasts sharply with the expansion observed in the rest of the Eurozone).

Lack of competitiveness.

But keep in mind the strengths of the economy:

a recurrent primary surplus ,

a low level of private debt and abundant domestic savings

a public debt held mainly by residents (at nearly 70%).

In addition, banks have started cleaning up their balance sheets and thus seem more resilient than a few years ago. The government has increased the duration of its debt (close to 7 years). The effective interest rate paid on its debt stock was close to 3% in 2017. In other words, at their current levels, interest rates do not impede public debt sustainability.

And should investors worry, the ECB would probably mobilise its anti-contagion instruments that would make it possible to stem the spread of financial turbulence to the rest of the Eurozone.

Admittedly, Italy is entering into unknown territory in terms of governance. There is radical uncertainty concerning the effective economic policy that will ultimately be put in place. If the coalition sticks to its programme, the confrontation with the EU is inevitable (on the fiscal side, the proposals amount to around € 100 bn, 6-7% of GDP). Keep in mind however that the coalition is fragile and has a slim majority in the Senate. In the event of any difficulty, there is a significant chance that the coalition will break up and, consequently, that new elections will be organised. All this is worth a specific political risk premium, significantly higher than that of the other peripheral countries. But we believe that the current fiscal proposals will be further watered down and smoothed over several years. Against this backdrop, there is no reason at this stage for the situation in Italy to affect either the Eurozone economic outlook, or the ECB agenda for QE exit by the end of the year.

TIMELINE FOR THE NEW GOVERNMENT

The new Government will have a busy international and domestic agenda outlined in the chart below. The key events in the short term would cover complex international issues.

The most important events will be the Eurogroup meeting (21 June) and the European Council meeting (28-29 June). Key topics for Italy are likely to be discussed, such as the Dublin treaty, EU reforms and renegotiation of the 2021-2027 budget, banking union and risk sharing. The weak government will probably have little negotiating power.

HOW IS ITALY DOING FROM AN ECONOMIC POINT OF VIEW

What to watch

The macro-environment that Italy faces is much more positive than the one during the Euro Sovereign Debt Crisis that developed in 2011. On the fundamental front, at the beginning of the year we expected the positive momentum of 2017 to be carried over into 2018 (albeit with some moderation on growth) maintaining output growth well above potential.

The recovery was well under way thus far: as of Q1 2018, Italy had expanded for fifteen quarters in a row, after experiencing somewhat extraordinary growth of 1.5% YoY in 2017 (vs. less than 1% in 2016), well above the estimated potential. This performance was supported by all engines of growth and especially by the recovery in Capital Investments, which had accelerated compared to the past two years and was broad based across sectors and capital goods. Support also came from personal consumption, with a sustained pace of consumption due to upbeat consumer confidence. Finally, net exports benefited from the expansion in global output and trade, supported by increased competitiveness. In addition, the positive environment created by ECB monetary policy helped sustain the recovery. Value added increased in all sectors, in particular in the industrial manufacturing sector. Labour market slack was gradually absorbed, although the unemployment rate still remains around 11%.

Overall, we still think that the economic fundamentals remain positive. However, we acknowledge that the current situation may significantly disturb business and consumer confidence, thereby affecting the real economy through postponed investment and consumption decisions. Overall, this is the key thing to watch in order to obtain early signals on activity.

Going forward, another important step would be the definition of the budget law, where the Government needs to find funding to avoid automatic VAT hikes in January 2019, which may significantly affect consumer behaviour.

In the Budget law for 2019, the government needs to find approximately EUR 12.5bn, to avoid VAT moving from 22% to 24.2% (ordinary rate) and from 10% to 12% (intermediate rate).

Also, in the Budget Law for 2020, the government needs to find EUR 19.1bn to avoid VAT moving from 24.2% to 24.9% (ordinary rate) and from 12% to 13% (intermediate rate) from 1 January 2020.

2018 BUDGET LAW

provisions and estimated path for government finances under the current law

Under the current law, the public finances are supposed to progress gradually but meaningfully towards a continuous improvement within the framework of the Stability and Growth Pact. The pillars of the 2018 Budget (and assumed Budget principles for the years 2019-2020), submitted to the European Commission, are as follows:

The budget plan for 2019-2020 aims to achieve a virtual balance in the final year. As for the period 2019-2020, the programme continues to show a significant deficit reduction (estimated at 0.9% of GDP in 2019 and 0.2% in 2020). The structural balance under the “no policy change” scenario should improve, reaching -0.6 per cent of GDP in 2019 and -0.2 per cent in 2020, leading to the achievement of Italy’s Medium-Term Objective (a balanced structural budget). Budgetary policy will be based on the continuation of the Spending Review process and the recovery of escape and evasion areas; progress on both of these profiles is essential to prevent the activation of VAT increases expected for 2019 and 2020.

Privatisation programme to continue: The 2017 forecast for privatisation revenue has been revised down, from 0.3% to 0.2% of GDP.

Public debt-to-GDP ratio to decline more rapidly in 2018- 2020. The debt-to-GDP ratio is projected to decline more markedly in the 2018-2020 period, reaching 123.9% in the final year. The government is firmly committed to achieving a larger reduction in the debt ratio over the medium/long term. In addition to the projected rise in the primary surplus to 1.9% of GDP, the decline is due to a decreasing gap between nominal GDP growth and the average funding cost, as well as more favourable stock-flow adjustments and larger privatisation revenue compared to 2016.

Needless to say, the budget law is likely to be substantially revised, putting debt sustainability at risk in the medium term.

THE DEBT ISSUE

Italy’s main problem is the high level of government debt, while private sector debt is not of concern. Although Government Finance is getting better (see 2018 Budget law projections), the high level of government debt represents a risk, although the high average maturity (6.9 years) provides some protection from the sudden transmission of higher interest rates into debt dynamics. 2018 financing needs are significant.

Key Figures:

Public Debt to GDP was 131.8% in 2017 (in 2016 it was 132%, small decrease but commitment to decrease further).

Deficit in 2017 was 2.3% of GDP (vs. 2.5% in 2016) with a target for 2018 of 1.6% of GDP (-0.7% from 2017). In the plans, it was projected there would be a progressive decrease in the deficit so as to reach a balanced budget in 2020 and a small surplus in 2021. Progressive and constant improvements since 2009 (-5% of GDP).

Primary surplus: +1.9% of GDP (slight improvement vs. 2016), with fiscal pressure on average decreasing from 42.7% to 42.5% in 2017.

Interest expense: from €83bn in 2012 down to an estimated €63bn in 2018 (around 3.5% of GDP).

Average debt maturity: 6.9 years.

Maturing debt between April and December 2018: €134bn (2019: €201bn).

Average issuance cost so far at the lowest level since 2000.

Effective interest rate paid on the stock of debt: almost 3% in 2017.

Debt holders (Bank of Italy report April 2018):

Italian bonds held by Bank of Italy 19.1%

Italian Banks’ debt decreased from 17.8% to 15.3%

Italian Families 5.4%

Non-domestic holders 33.2%

INVESTOR BASE AT END 2017

Italy stands out very clearly from the other countries. In addition,

If we include the holdings of foreign central banks (“foreign official” item, including the ECB under the SMP programme - €50bn in securities held at the end of 2017), we obtain 83% of debt that is not likely to be sold in the short term.

Estimates by the Bank of Italy show that more than 60% of the debt held by foreigners is held by residents of the EZ (meaning that only about 13% of Italian debt is held by investors outside the EZ).

Among the investors outside the EZ, significant shares are held by both the private sector and the public sector (consisting of central banks and generally governments).

By country, the main EZ holders of BTPs are France and Luxembourg, followed by Germany and Spain; outside the EZ, they are the US, the UK, China and Japan.

The holdings by Luxembourg and other countries with a large fund industry presumably reflect, to alarge extent, a “round-tripping” phenomenon where Italian investors purchase units of mutual fundsbased in these countries, which in turn reinvest into Italian assets including Italian government debt.

According to the Bank of Italy, the relevance of “round-tripping” may be roughly estimated at between 10% and 16% of total foreign holdings of Italian government debt.

THE BANKING SECTOR

The banks situation has improved. The Bank of Italy has done stress tests. The effect on banks has been assessed by examining three scenarios in which risk-free interest rates rise by 100, 200 and 300 basis points over the entire yield curve, assuming constant risk premiums, compared with a baseline scenario in which interest rates stay at the same level as at the end of January 2018.

The results show that even in the worst case scenario, where the system’s average liquidity coverage ratio (LCR1) decreases from 172 to 143%, it would still be well above the regulatory minimum of 100%.

In the scenario assuming a 100 bp rise in risk-free interest rates, 2.6% of banks would fall below the threshold, representing 2.7% of total assets.

These figures would rise to:

4.3 and 5.0 % respectively in the middle scenario,

4.6 and 5.4% respectively in the worst case scenario.

Overall, Italy’s banking system has satisfactory levels of liquid assets to weather even very large increases in risk-free interest rates. Italian banks have little exposure to interest rate risk, measured by the change in the net economic value of the balance sheet (assets minus liabilities in the banking book) that can result from shifts in the risk-free yield curve (see the Financial stability Report of the Bank of Italy, April 2018).

EUROZONE: SOME KEY DATA

USARDI Annalisa , CFA, Senior Economist

BOROWSKI Didier , Head of Macroeconomic Research

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Italy: troubled waters and complex challenges ahead but no Italexit on the roadmap!